How Does a 401(k) Work with Michelle Cannan, CPFA™, QKA®, QKC

April 30, 2024

How Does a 401(k) Work with Michelle Cannan, CPFA™, QKA®, QKC

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How Does a 401(k) Work with Michelle Cannan, CPFA™, QKA®, QKC Show Notes

As Modern Wealth Management continues to grow, one of the additions we’re very excited about is our office in Rochester, New York. Our Rochester-based team members specialize in 401(k) plans, which are typically people’s largest asset as they head into retirement. So, we figured it would be good idea to have Michelle Cannan, CPFA™, QKA®, QKC, our head of company retirement plan services and managing director of our Rochester office, join Dean Barber on The Guided Retirement Show to discuss how a 401(k) plan works and many other nuances about 401(k)s.

Along with covering how a 401(k) works for plan participants, Michelle will share a little bit about the roles of the plan sponsor and plan provider.

In this podcast interview, you’ll learn:

  • How Our Team of Retirement Plan Advisors Works with 401(k) Plan Sponsors
  • The Roles of Retirement Plan Advisor, Record Keeper, Sponsor, and Participant with How a 401(k) Plan Works
  • How 401(k) Plan Automatic Enrollment Works
  • Roth vs. Traditional Considerations

How Our Team of Retirement Plan Advisors Works with 401(k) Plan Sponsors

At Modern Wealth, we have a team of retirement plan advisors who help plan sponsors with four main things.

  1. The first thing is investment selection and monitoring. They decide which investments will be available to employees to select in a retirement plan.
  2. The next thing is plan administration. Every retirement plan is designed differently to suit the needs of the company and the employees. There are no two 401(k)s that operate the same way. Our team at Modern Wealth helps to ensure that the plan is administered correctly, per the documents. There are also a lot of required documents and government filings associated with maintaining a 401(k) plan. Our team provides assistance with those.
  3. Our team also provides assistance with different service providers. With each retirement plan, there are different vendors that work to provide services. Our team supports the selection and monitoring of those service providers. We also conduct fee benchmarking, which is important to make sure that we’re ensuring everybody is paid reasonable plan expenses.
  4. Last, but not least, our team provides employee education. That’s important for individuals who are participants in retirement plans and for business owners. Business owners are obligated to provide employees with enough information to be informed investors. That’s why our team offers an education program that includes group and individual meetings. The program focuses on helping employees understand the retirement plan benefit and the importance of saving.

The Retirement Plan Record Keeper’s Role with How a 401(k) Works

There’s a retirement plan record keeper that plays a key role with how a 401(k) works. The record keeper is the company who tracks who is in the plan, what investments they own, and what funds are deposited and withdrawn. They also maintain the website where people go to log in to view their accounts. Wherever you go to log in to view your 401(k) plan, that’s your record keeper.

The Plan Sponsor’s Role with How a 401(k) Works

Now, let’s review the plan sponsor’s role. The plan sponsor is the employer or the company that offers a retirement plan benefit for their employees. Most commonly, it’s a 401(k). But it can also be a 403(b) for nonprofit companies, a pension plan, or other types of retirement plans.

The plan sponsor is considered as a fiduciary. That means that any decisions regarding the retirement plan benefit need to be made in the best interest of plan participants. Offering a retirement plan benefit comes with a lot of responsibilities. The plan sponsor needs to make sure the fees are reasonable, the plan is in compliance with all the laws and regulations, monitor the vendors that work with the plan, and ensure that employees receive enough information to be informed investors.

The Responsibility of the Plan Participant

As a financial advisor, Dean has heard many clients and prospective clients say that their companies did all the work with picking the investments and acting as a fiduciary. They think that they don’t need to worry about anything with their plan because their company has done all the work. But the reality is that the onus of the success of a 401(k) plan doesn’t lie on the shoulders of either the plan sponsor, plan provider, or plan advisor. It lies squarely on the shoulders of the plan participant themselves.

“It’s your money that’s going in. The company may provide a match, but it’s your responsibility to understand what those investment choices are and make an informed decision as to where and how that money should be invested.” – Dean Barber

Automatic Enrollment

That misconception has become more common over time because a lot of 401(k) plans now have automatic enrollment. If an employee is a new hire at a company and they don’t make any election at all, they will automatically be enrolled in the plan at a rate designated by the plan sponsor. However, that might not be enough for them to meet their retirement goals.

“I’ve seen plan sponsors say they will automatically enroll people at 1% or 3% of pay. Oftentimes, that’s not enough for the individual to have a successful retirement.” – Michelle Cannan, CPFA™, QKA®, QKC

The Financial Planner’s Role with How a 401(k) Works

When somebody gets automatically enrolled, they usually get enrolled in the traditional, pre-tax side of their 401(k) as opposed to the after-tax Roth side. That might not be what the plan participant wants, though.

This is where the financial planner’s role of how a 401(k) works can come into play. A financial planner can help the plan participant through the Roth vs. traditional decision. Should you contribute to traditional, Roth, or a combination of the two? Where should the company match go? And how much should you contribute?

“Those are all questions that every employee should be asking themselves when it comes to their 401(k) plan. It’s not just about the underlying investment.” – Dean Barber

Your CPA’s Role with How a 401(k) Works

Modern Wealth’s retirement plan advisors have a very comprehensive education program that we take clients through, but Michelle says it’s still not as personalized or as thorough as what a plan participant can receive when working with one of our financial planners.

“Our education program helps people with the accumulation phase. It helps decide how much to put in, Roth versus pre-tax. But every person has a little bit of a different scenario. It helps when there is a financial planner involved and maybe your CPA as well.” – Michelle Cannan, CPFA™, QKA®, QKC

A CPA can be helpful with the Roth vs. traditional decision. That isn’t just a decision you need to make when you enroll in a 401(k) plan. It needs to be a decision that you make on an annual basis based upon you and your partner’s incomes and how much you need to spend each month now and in future years. How you save now can dictate how you end up spending later.

That’s why financial planning is key as you’re planning to get to and through retirement. It’s important to have a team of professionals—especially a financial planner and a CPA that work together—that’s working for you to help make those personalized decisions with your 401(k).

Roth vs. Traditional Considerations

There are various pros and cons to both sides of the Roth vs. traditional decision. It’s important to have a forward-looking approach every time you think about it, which isn’t always easy to do.

Remember, though, that after you retire and you’re taking money out of your Roth accounts, that money will come out tax-free since you paid tax on the contribution. Contributions to the traditional side of your 401(k) are tax-deferred—meaning that money won’t be taxed until you take it out. Therefore, it’s important to think about your sources of income today compared to your sources of income in retirement and how they’re taxed.

Considering Roth Conversions

If you’re in your peak-earning years, it could make sense to contribute to the traditional side of your 401(k) just before retirement. Doing that could lead to getting a bigger deduction, and then you could do some Roth conversionsconverting traditional IRA funds to a Roth IRA—in your first few years of retirement. Along with health care costs, taxes can be a leading wealth-eroding factor in retirement, so having funds that are growing tax-free in a Roth IRA can be advantageous.

“That’s where the financial planner creates that forward-looking plan and says, ‘What do you want the rest of your life to look like? What are taxes going to look like in the future? Then, they can help that individual make an informed decision.” – Dean Barber

Roth IRA Income Limits

One thing that a lot of people don’t realize is that Roth 401(k) contributions don’t have an income limit like Roth IRAs do. If you earn over a certain dollar limit, you can’t contribute to a Roth IRA.

But in the 401(k) plan, a Roth 401(k) contribution can happen for anyone, regardless of income. The Roth 401(k) limits are up to the regular IRS 401(k) limits. In 2024, it’s $23,000. That increases to $30,500 if you’re 50 or older and make a full catch-up contribution.

“There’s no better tax rate than 0%, and that’s what you get with the Roth portion of your 401(k) and the Roth IRA.” – Dean Barber

In-Plan Roth Conversions

Some plans, depending on what’s available, allow in-plan Roth conversions. You can take any pre-tax source that’s in your 401(k) and convert that to Roth. One of our CPAs, Marty James, CPA, PFS, joined Dean and Bud Kasper, CFP®, AIF® on America’s Wealth Management Show to discuss how to maximize in-plan Roth conversions, so make sure to check out that episode if you missed it.

In-plan conversions could be a great planning opportunity of you. But there are some instances where they may not be. It’s another example that a big part of understanding how your 401(k) works is realizing that the decisions you make with your 401(k) are individualized.

Some planning opportunities within your 401(k) might make a lot of sense for your friend or colleague but not for you—and vice versa. Make sure you’re working with a team of wealth management professionals who can help you make the best decisions for you.

The Roth IRA Five-Year Rule

Another thing to know about Roth 401(k)s is that if you retire and then transfer your Roth 401(k) to a Roth IRA, the Roth IRA five-year time clock starts over unless you’re transferring it to an existing Roth IRA. That’s the case even if that Roth money has been in the 401(k) plan for more than five years.

“If you’re using your 401(k) as a strategy to accumulate Roth (funds), make sure that you’re working with a planner in advance to see if have enough money available. Then, start that five-year time clock before you retire, if possible, outside of the plan if you have an existing Roth IRA.” – Michelle Cannan, CPFA™, QKA®, QKC

Many people understand that there’s a 10% penalty if they pull money out of a Roth IRA before five years or until they’ve attained age 59.5. Both those things need to have happened for you to get a total tax-free withdrawal.

However, that penalty only applies to the earnings of the Roth IRA. For example, let’s say that you’re 60 and had $100,000 that was in the Roth portion of your 401(k) that you’ve rolled over to a Roth IRA. You can spend that entire $100,000 within that five-year period because it’s taxed at a last-in, first-out basis. It’s only when you exceed that $100,000 that the penalty applies.

“Understanding those rules are also critical. I don’t want someone to think that they need to have a Roth in place to roll that over into a Roth or that they can’t access any of that money without a penalty because they can always access the amount that went into that plan.” – Dean Barber

401(k) Considerations If You’re Changing Jobs

As we continue discussing how a 401(k) works, there are some key considerations to keep in mind if you’re changing jobs. You can leave the money with the existing plan provider, the existing plan sponsor, and all the fiduciary rules are still intact. All the investments would remain the same.

Another option is to take that money and roll it directly to the new company’s plan. Or you can take that money, roll it to an IRA, and be in full control over the underlying investments.

“A lot of people get confused when it comes to these rollover rules. They’re pretty stringent, and if you make a mistake, it can cost you dearly.” – Dean Barber

There is also the option to take it in cash, but we never like to see that. That could set you back quite a bit from retirement. When we’re talking about distributions, we just always want to mention all possible types of distribution.

When Dean started his career in the late 1980s, many people did do the cash option knowing that they had 60 days to get that into an IRA. But there’s going to be an automatic 20% withholding just for federal taxes. If you’re like Michelle and live in a high tax state like New York State, that’s another maybe 7% on top of that.

Direct Rollovers

Let’s use the $100,000 example again. If you want to roll that $100,000 over, you need to come up with the full $100,000 to roll to an IRA within 60 days. If you do that, whatever taxes were withheld, federal and state, you’ll get those back when you file your tax return. To avoid that complication, you can do a direct rollover, where you can request for the plan provider to make the check out to the IRA of yourself or to the new company plan, not to you directly. That avoids the automatic withholding and the 60-day rule.

In-Service Withdrawals

Now, let’s talk about in-service withdrawals. Not all plans have an in-service withdrawal, but some plans do. That allows an individual while they’re still employed to do a withdrawal from that 401(k), rolling directly to an IRA to open additional investment choices.

“(This option) should be more commonplace than it is. We have seen more plans adopt this over time, but we like to see is retirement plans that allow you to request an in-service withdrawal or a rollover to an IRA at age 59.5.” – Michelle Cannan, CPFA™, QKA®, QKC

That allows you full flexibility to take any of your account balance and move it to an IRA to work with a financial planner, possibly before you retire so you can prepare for that. The option of in-service withdrawals can offer the plan participant a lot more flexibility and control, especially in the years leading up to retirement.

You can still continue contributing to the plan right after you take an in-service withdrawal or in-service rollover. You can still receive any company contributions that might be in your plan. It just allows you to work with your financial planner before your retirement date.

Understanding the Employee Retirement Income Security Act (ERISA)

We also can’t have a discussion about how 401(k)s work without talking about beneficiary rules. The Employee Retirement Income Security Act (ERISA) was a law that passed in 1974,1 which outlined some very specific rules regarding beneficiary rules for 401(k)s.

“It’s very important to have a beneficiary election for your retirement plan account. It’s very easy to make the election. With most record keepers, you can log in to your 401(k) account and make the beneficiary election online.” – Michelle Cannan, CPFA™, QKA®, QKC

By law, if there is no beneficiary named on the account, your spouse is the default. However, Michelle has seen some record keepers have the spouse as half of the default and the other half goes to your estate. That can create some major tax complications. You can also name secondary or contingent beneficiaries, so you have a plan in place if something were to happen to you and your spouse.

Potential Issues to Avoid Regarding Beneficiaries

There are several common problematic scenarios that Michelle has seen with people naming beneficiaries. For example, let’s say someone elects non-spouse beneficiaries and then they get married to somebody else. The spouse is automatically your beneficiary unless the spouse signs a spousal waiver form indicating they understand they will not receive the benefit. That form usually requires a notarized signature.

“That’s created a lot of time in court for a lot of people that have tried to fight that. The ERISA rules are going to triumph what any person thinks is logical.” – Dean Barber

Net Unrealized Appreciation

As we begin to wrap up with describing how a 401(k) works, we want to discuss something that specifically relates to publicly traded companies that have company stock as an investment option in the 401(k). There’s a little-known part of the tax code that relates to something called Net Unrealized Appreciation (NUA).

NUA applies only to publicly-traded stock where that stock is available for purchase inside the 401(k) plan. It’s a huge tax savings and tax planning opportunity if it’s understood.

When you have company stock in your 401(k) plan, if you take a lump sum distribution of all the stock in that account, you can pay lower capital gains rates on a portion of that instead of paying the typically higher ordinary income tax rate. It’s the difference between the price you initially paid for the stock and its current market value.

For example, if you work for Nvidia, Microsoft, Apple, Meta, Google, or those types of companies where maybe you didn’t contribute a ton of money and your contribution is considered your cost of the stock (your basis), any appreciation in that stock is considered to be gains. That’s why I call it Net Unrealized Appreciation. When you take that lump sum distribution, you’ll pay ordinary tax on the cost. Anything above that will be treated as a long-term capital gain.

“When it comes to getting money out of a company-sponsored plan, don’t try to do this on your own. Get some professional help because there’s a lot of nuances to this. And if you make a mistake, the IRS doesn’t give you a do over.” – Dean Barber

There Aren’t Mulligans with 401(k) Distributions and IRA-to-IRA Transfers

Dean thinks about it like his golf game. If he hits a bad shot, he might give himself a mulligan. Well, there are no mulligans when it comes to distributions from 401(k)s and even IRA-to-IRA transfers. There are a lot of rules that come along with those. Again, 401(k)s oftentimes end up being people’s largest asset as they head into retirement. It’s important to work with a team of wealth management professionals so that you truly understand how your 401(k) works.

We’re thankful to have Michelle and her team of retirement plan advisors on board at Modern Wealth to help with educating people about how their 401(k) works and why it’s a crucial aspect of wealth management. If you have any questions about what Michelle and Dean covered, start a conversation with our team below.

Schedule a Meeting

You work hard to get the money into your 401(k) plan, so we want to make sure that money ends up working for you in the most tax-efficient way possible once you’re in retirement. Remember that it’s not about what you save when it comes to your 401(k) or other income sources; it’s what you get to keep.

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Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.